International equity markets are an important platform
for global finance. They not only ensure the participation of a wide variety of
participants but also offer global economies opportunities to prosper.
But then, before investing in the international equity
markets, one needs to learn how these markets are composed, elements that
control them and other factors that influence the markets and investment
returns
To understand the importance of international equity
markets, market valuations and turnovers are important tools. Moreover, we must
also learn how these markets are composed and the elements that govern them.
Cross-listing, Yankee stocks, ADRs and GRS are important elements of equity
markets.
This article is aimed at expounding
investors` knowledge on the factors that affect the returns from international
equity markets.
Market Structure, Trading Practices, and Costs
The secondary equity markets provide
marketability and share valuation. Investors or traders who purchase shares
from the issuing company in the primary market may not desire to own them
forever. The secondary market permits the shareholders to reduce the ownership
of unwanted shares and lets the buyers to buy the stock.
The secondary market consists of brokers who represent the public buyers and sellers. There are two kinds of orders − Market order − A market order is traded at the best price available in the market, which is the market price.
Limit order − A limit order is held in a limit order book until the desired price is obtained.
There are many different designs for secondary markets. A secondary market is structured as a dealer market or an agency market.
In a dealer market, the broker takes the trade through the dealer. Public traders do not directly trade with one another in a dealer market. The over-the-counter (OTC) market is a dealer market.
In an agency market, the broker gets client’s orders via an agent.
Not all stock market systems provide continuous
trading. For example, the Paris Bourse was traditionally
a call market where an agent gathers a batch of orders that
are periodically executed throughout the trading day. The major disadvantage of
a call market is that the traders do not know the bid and ask quotations prior
to the call.
Crowd trading is a form
of non-continuous trade. In crowd trading, in a trading ring,
an agent periodically announces the issue. The traders then announce their bid
and ask prices, and look for counterparts to a trade. Unlike a call market
which has a common price for all trades, several trades may occur at different
prices.
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Trading In International Equities
A greater global integration of capital markets became apparent for various reasons −
First, investors understood the good effects of international trade.
Second, the prominent capital markets got more liberalized through the elimination of fixed trading commissions.
Third, internet and information and communication technology facilitated efficient and fair trading in international stocks.
Fourth, the MNCs understood the advantages of sourcing new capital internationally.
Cross-listing
Cross-listing refers to having the shares listed on one or more foreign exchanges. In particular, MNCs do this generally, but non-MNCs also cross-list. A firm may decide to cross-list its shares for the following reasons −
Cross-listing provides a way to expand the investor’s base, thus potentially increasing its demand in a new market.
Cross-listing offers recognition of the company in a new capital market, thus allowing the firm to source new equity or debt capital from local investors.
Cross-listing offers more investors. International portfolio diversification is possible for investors when they trade on their own stock exchange.
Cross-listing may be seen as a signal to investors that improved corporate governance is imminent.
Cross-listing diminishes the probability of a hostile takeover of the firm via the broader investor base formed for the firm’s shares.
Factors Affecting International Equity Returns
The ultimate goal of any
investment is to maximize profits or returns. Therefore any investor going to
international equity market must put into considerations these factors that
affect international equity market returns. Macroeconomic factors, exchange
rates, and industrial structures affect international equity returns. These
factors are known as macroeconomic factors. They are:
· Exchange rates
· Demand and supply of
currency in Forex market
· Foreign exchange policies
· Industrial production
· Interest rates
· Inflation
· Monetary assets
Macroeconomic Factors
Solnik (1984) examined the
effect of exchange rate fluctuations, interest rate differences, the domestic
interest rate, and changes in domestic inflation expectations. He found that
international monetary variables had only weak influence on equity returns.
Asprem (1989) stated that fluctuations in industrial production, employment,
imports, interest rates, and an inflation measure affect a small portion of the
equity returns.
Exchange Rates
Due to demand and supply, there is always an exchange
rate that keeps changing over time. The rate of exchange is the price of one
currency expressed in terms of another. Due to increased or decreased demand,
the currency of a country always has to maintain an exchange rate. The more the
exchange rate, the more is the demand of that currency in forex markets.
Exchanging the currencies refer to trading of one
currency for another. The value at which an exchange of currencies takes place
is known as the exchange rate. The exchange rate can be regarded as
the price of one particular currency expressed in terms of the other one, such
as £1 (GBP) exchanging for US$1.50 cents.
The equilibrium between supply and demand of
currencies is known as the equilibrium exchange rate.
Industrial
Structure
Roll (1992) concluded that the industrial
structure of a country was important in explaining a significant part of the
correlation structure of international equity index returns.
In contrast, Eun and Resnick (1984) found that
the correlation structure of international security returns could be better
estimated by recognized country factors rather than industry factors.
Heston and Rouwenhorst (1994) stated that
“industrial structure explains very little of the cross-sectional difference in
country returns volatility, and that the low correlation between country
indices is almost completely due to country-specific sources of variation.”
Economic
Exposure – An Example
Consider a big U.S. multinational with
operations in numerous countries around the world. The company’s biggest export
markets are Europe and Japan, which together offer 40% of the company’s annual
revenues.
The company’s management had factored in an
average slump of 3% for the dollar against the Euro and Chinese Yuan for the
running and the next two years. The management expected that the Dollar will be
bearish due to the recurring U.S. budget deadlock, and growing fiscal and
current account deficits, which they expected would affect the exchange rate.
However, the rapidly improving U.S. economy has
triggered speculation that the Fed will tighten monetary policy very soon. The
Dollar is rallying, and in the last few months, it has gained about 5% against
the Euro and the Yuan. The outlook suggests further gains, as the monetary
policy in China is stimulative and the European economy is coming out of
recession.
The U.S. company is now facing not just
transaction exposure (as its large export sales) and translation exposure (as
it has subsidiaries worldwide), but also economic exposure. The Dollar was
expected to decline about 3% annually against the Euro and the Yuan, but it has
already gained 5% versus these currencies, which is a variance of 8 percentage
points at hand. This will have a negative effect on sales and cash flows. The
investors have to take into account the currency fluctuations and the
stock of the company falls 7%.
Monetary Assets
Monetary assets are cash in possession of a corporation, country,
or a company. There is always some demand and an equivalent amount of supply
for each country’s currency. The cash in hand determines the strength of an
economy.
Monetary assets have a dollar value that will not change with
time. These assets have a constant numerical value. For example, a dollar is
always a dollar. The numbers will not change even if the purchasing power of
the currency changes.
We can understand this concept by contrasting them against a
non-monetary item like a production facility. A production facility’s value –
its price denoted by a number of dollars – may fluctuate in future. It may lose
or gain value over the years. So a company owning the factory may record the
factory as being worth $500,000 one year and $480,000 the next. But, if the
company has $500,000 in cash, it will be recorded as $500,000 every year.
In other words, monetary items are just cash. It can be a debt
owed by an entity, a debt owed to it, or a cash reserve in its account.
For example, if a company owes $40,000 for goods delivered by a
supplier. It will be recorded at $40,000 three months later even though, the
company may have to pay $3,000 more because of inflation.
Similarly, if a company has $300,000 in cash, that $300,000 is a
monetary asset and will be recorded as $300,000 even when, five years later, it
may be able to only buy $280,000 worth of goods compared to when it was first
recorded five years ago.
Demand and Supply of Currency in Forex Market
The demand for currencies in forex markets arise from the demand
for a country’s exports. Also, speculators who are looking for a profit relying
on the changes in currency values create demand.
The supply of a particular currency is derived by domestic demands
for imports from the foreign nations. For example, let us suppose the UK has
imported some cars from Japan. So, UK must pay the price of cars in Yen (¥),
and it will have to buy Yen. To buy Yen, it must sell (supply) Pounds. The more
the imports, the greater will be the supply of Pounds onto the Forex market.
Interest Rate
What is Interest Rate Parity?
Interest Rate Parity (IRP) is a theory in which
the differential between the interest rates of two countries remains equal to
the differential calculated by using the forward exchange rate and the spot
exchange rate techniques. Interest rate parity connects interest, spot
exchange, and foreign exchange rates. It plays a crucial role in Forex markets.
IRP theory comes handy in analyzing the
relationship between the spot rate and a relevant forward (future) rate of
currencies. According to this theory, there will be no arbitrage in interest
rate differentials between two different currencies and the differential will
be reflected in the discount or premium for the forward exchange rate on the
foreign exchange.
The theory also stresses on the fact that the
size of the forward premium or discount on a foreign currency is equal to the
difference between the spot and forward interest rates of the countries in
comparison.
Example
Case
I: Home Investment
In the US, let the spot exchange rate be $1.2245
/ €1.
So, practically, we get an exchange for our
€1000 @ $1.2245 = $1224.50
We can invest this money $1224.50 at the rate of
3% for 1 year which yields $1261.79 at the end of the year.
Case
II: International Investment
We can also invest €1000 in an international
market, where the rate of interest is 5.0% for 1 year.
So, €1000 @ of 5% for 1 year = €1051.27
Let the forward exchange rate be $1.20025 / €1.
So, we buy forward 1 year in the future exchange
rate at $1.20025/€1 since we need to convert our €1000 back to the domestic
currency, i.e., the U.S. Dollar.
Then, we can convert € 1051.27 @ $1.20025 =
$1261.79
Thus, when there is no arbitrage, the
Return on Investment (ROI) is equal in both cases, regardless the choice of
investment method.
Arbitrage is the activity of purchasing shares
or currency in one financial market and selling it at a premium (profit) in
another.
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Foreign Exchange Policy
Foreign exchange policy of the country is very critical in deciding whether or not to invest in a country`s equity market. You should look at the possibility of repatriating your profits through dividend. Some countries do not give priority to you as you aim to repatriate your profits; they make the process difficult for foreign investors to repatriate their profits, an attempt to ensure that funds do not leave their economies.